Strategic Acquisition And Growth Strategies For Northrop Grumman

Summary

Winning the B3 contract and increasing FCF should encourage them to go on the hunt.

Northrop Grumman is the leading producer of drones, but has the opportunity to expand and monopolize.

Acquisitions of cyber security firms will lead to increased revenue, as it is becoming a secular trend.

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As I wrote in a prior article, I believe Northrop Grumman (NYSE:NOC) is one of the Aerospace & Defense companies best set to succeed in this increasingly volatile world filled with a need for more drones and cyber security / attack software. I believe Northrop Grumman will be one of the best-performing A&D stocks in 2016, but believe the company can do better to increase shareholder value than just increasing the dividend and buying back stock. Northrop Grumman has been lackluster on the acquisition front when compared to its peers, and I believe these suggestions would increase profitability immensely.

Executive Summary

Expanding current profitable sectors

M&A Opportunities

Expanding new profitable sectors

Benefits

UAV/S / UCAS

Drone spending on the rise

Increased revenue

B3-Bomber

Secure exclusive deal with the Air Force

Increased revenue through repairs and upgrades

Cyber Security

Bolster cyber division

Increase revenue

Edge out competitors

Air Industries Group

Improve supply chain management

AeroVironment

Increase contracts with the DOD

Expand into commercial drone market

Code DX

Bolster cyber division

Expand into commercial market

Increase revenue

Kratos Defense & Security Solutions

Improve C41SR division

Orbital ATK Inc.

Expand space sector

Lighter Than Air

Enter frontier market

Increase revenue

Naval UAV/S / UCAS

Enter frontier market, become pioneer

Increase revenue

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A.Expanding current profitable sectors:

1. UAV/S's/UCAS: Drones have come to the forefront of modern surveillance and security operations, enabling the United States to more effectively and efficiently conduct military operations in the Middle East. As UAV's sophistication has grown from simple radar for surveillance to UCASs able to carry payloads, the demand for drones has skyrocketed. Below is a chart demonstrating this burgeoning demand for drones and the huge increase in expenditure for drones by the U.S. government.

Northrop Grumman has been very successful financially with the rollout of the RQ-4/MQ-4 Global Hawk UAV for both the US Airforce and Navy with 42 built and now in service. As the enemy has become more adept at shooting down jets with pilots using SAMs, an emphasis has been made to use "smart" unmanned devices with both radar and capable payload delivery systems. General Atomics has had some of the most success with UCAS projects, with both the MQ1 Predator and MQ9 Reaper receiving huge contracts, with over 460 built primarily for the Air Force as well as other agencies.

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Northrop Grumman has a real opportunity to penetrate this market and increase revenue with its proposed X47-C, which is currently under development.

Drones are finding new markets for purposes other than military usage. The FBI as well as US Customs and Border Agency have begun using UAVs for surveillance of the border as well as criminal investigations. That's not all. Recent events continue to illustrate the need for these products, such as the continual surge in illegal immigration at the border or the prison break in upstate New York. Drones are now starting to gain prominence in the commercial sector as well. The FAA has begun loosening regulations concerning "drones", and has begun allowing companies such as Amazon (NASDAQ:AMZN) and Alphabet (NASDAQ:GOOG) to test their products on short-radius deliveries.

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Northrop Grumman has a strong UAV/S sector, a growing UCAS sector which should be aggressively pursued, and an opportunity to enter and dominate the commercial sector.

2. B3 Bomber: This was an immensely huge win for Northrop Grumman. The Air Force has requested 80-100 units at a price of $550 million apiece. Not only was that a must-win contract for NG in terms of increasing net revenue and free cash flow, but it will provide a revenue stream for the next 40 years, as the planes will need constant repairs and modifications, which provide additional revenue streams. Lockheed Martin (NYSE:LMT) and Boeing's (NYSE:BA) partnership on the LRSB project yielded a formidable opponent in the race. However, as the old expression goes, "Keep your friends close, and your enemies closer".

3. Cybersecurity: Along with the BAM division, NG is known for having a leading cybersecurity division amongst its A&D peers. The multiple recent breaches in supposedly protected software in the commercial sector is frightening, to say the least, and potentially catastrophic from a military perspective. Cybersecurity will undoubtedly play a huge role in the future of the defense industry and will likely become one of the largest and most profitable financial opportunities of the 21st century (see graph below):

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Funding in 2014 broke the $2 billion barrier for the first time, while M&A deals continued their steady ascent growing to 269 deals. However, according to FBR Capital Markets, there could be a 20% increase in "next-generation cyber security spending" this year (2015), and capital input is projected to reach $15 billion to $20 billion in the next 3 years. Competitors such as Raytheon (NYSE:RTN) have recognized the importance of this relatively new but increasingly important industry, and have made strategic acquisitions, such as its purchase of Websense to bolster its cyber division. Northrop Grumman should take the time to analyze potential acquisition candidates that may be available at a sub-premium valuation before the cybersecurity wave raises the value of the sector across the board. Cybersecurity has seen a burst of investment and attraction as of late, but it may still be possible to acquire companies before the valuations skyrocket.

B.Merger & Acquisition Opportunities:

1. Air Industries Group (NYSEMKT:AIRI): Northrop Grumman can become even bigger and more successful by acquiring smaller but relevant and valuable companies. Air Industries Group, for example, may be an attractive potential acquisition candidate. This small cap aerospace and defense company is structured as a holding company with four subsidiaries, based out of Long Island. Among many other products, it produces all E-2 Hawkeye, C2-A Greyhound, and F-18 Hornet parts, which are among Northrop Grumman's major aerospace products. Acquiring a company such as this could bolster production and improve the supply chain management within the NG Corporation. With a market cap of fewer than $80 million, AIRI seems like a relatively inexpensive purchase for a company that would help improve the speed and efficiency of NG's assembly process as well as the rates at which the company negotiates with its suppliers.

2.AeroVironment (NASDAQ:AVAV): AeroVironment is a rapidly growing technology company based out of Simi Valley and Monrovia California. It is well known for a variety of energy and electrical systems as well as, more importantly, UAVs. AVAV is the Pentagon's top supplier of small drones. Expanding the UAV/UCAS department of Northrop Grumman may be critical to maintain relevancy in these changing times of warfare. Acquiring this company would bolster relationships with both the US Government [DOD] and Lockheed Martin. AeroVironment currently partners with Lockheed Martin in international markets, a growing consumer sector. AVAV currently has a market cap of $624 million. With an estimated $24 billion in revenue, NG certainly has enough cash to purchase a midcap aerospace company like AVAV as well as AIRI if the price and environment were favorable. Purchasing AeroVironment also allows Northrop Grumman to become more involved in the commercial sector. AVAV has had a successful run since its inception in 1971. However, last year's performance was mediocre, at best. Its sales were flat, the stock price was hammered, and the earnings were nothing spectacular. AeroVironment is a company "on sale", with a bright future and a backlog of commercial and DOD contracts. With Northrop Grumman's leadership, AeroVironment's products could ascend to the next level and become an important part of the NG business structures as a subdivision of the currently profitable BAM division.

3. Code DX: Code DX is a provider of a robust suite of fast and affordable tools that help software developers and security analysts find, prioritize, and visualize software vulnerabilities. It is a private small to midcap cyber security firm with a growing backlog of orders. Code Dx has been awarded multiple SBIR grants from the DHS, totaling millions of dollars, and is ranked #15 on the Cyber Security 500. This company is also headquartered out of Northport, NY, near the NG Bethpage location. With many Northrop Grumman offices still on Long Island, integration of Code DX into the larger NG family would be a relatively smooth and easy transition for both parties concerned. Besides a bolstered cyber security for government contracts, its central location on Long Island would also allow access to the greater NY markets for private commercial contracts which could potentially generate hundreds of millions, possibly billions, of dollars for NG.

4.Kratos Defense & Security Solutions Inc. (NASDAQ:KTOS): Kratos is headquartered in San Diego, California, and provides defense, information technology, information assurance and security products for the government. Services include information technology, C41SR, weapon systems maintenance, engineering services and much more. Kratos is a small cap defense company valued at approximately ~$400 million. This is yet another opportunity to buy another cheap company with existing government contracts and bolster the C41SR and IT sections of NG.

5. Orbital ATK Inc. (NYSE:OA): OA was formed by the merger of Orbital Sciences Corporation and Alliant Techsystems. This newly formed corporation builds and delivers space, defense and aviation-related systems as a contractor and as a merchant supplier. Its main products include launch vehicles and related propulsion systems; satellites and associated components & services, and finally, tactical missiles, defense electronics, and medium-to-large caliber ammunition. CEO Wes Bush has begun increasing Northrop Grumman's space division by allocating more assets to the sector and putting an increased focus on the sector. In the last few years, NG has launched a fully functioning satellite built to track soil moisture, and has begun a mirror replacement manufacturing businesses for satellites with damaged mirrors. Orbital ATK brought in around $4.5 billion in revenue last year. Besides being an enormously profitable company, the acquisition of OA will allow NG to bolster its defense businesses, while rapidly expanding its space division, something it has a great desire to do. Orbital ATK is the largest company on this acquisition list with a market cap of $4.5 billion. While more expensive than the other companies on this list, OA has the greatest potential to expand Northrop Grumman's business model across multiple sectors and increase future growth potential and government contracts. Orbital ATK is run by an excellent management team, most notably president and CEO David Thompson who attended Massachusetts Institute of Technology and California Institute of Technology for aeronautics degrees, and finally, Harvard Business School. Northrop Grumman does not have enough cash reserves to buy a company the size of Orbital ATK, and would require syndicated loans from large financial institutions. However, the acquisition of Orbital ATK would be immeasurably beneficial to the Northrop Grumman Corporation, even if it meant taking on short-term debt.

C. Expanding into new profitable sectors:

Northrop Grumman (like Raytheon) is heavily committed to the military sector, but companies like Lockheed and Boeing are able to continue strong sales even when the military budget is cut because of the strong support of their commercial sector. Making drones for the commercial sector, or continuing with other proposed projects, could be extremely profitable:

1. Lighter Than Air:

Projects such as Lighter Than Air (LTA) may be profitable ventures. While LTA's estimated 15% profit is not stellar compared to NG's current projects, being a pioneer in a frontier market is a promising opportunity. The following Seeking Alpha news feed dated 6/17/15 may be telling and prophetic:

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Northrop Grumman had the opportunity to be a pioneer in the market of large freight airships carrying oil, mining materials, or goods to remote villages or areas that are inaccessible due to a lack of roads. This idea was a winner: NG has the wherewithal to compete with Lockheed Martin for this business. Portfolio diversification seems to be working for Boeing and Lockheed Martin, and may be an avenue for NG to explore as well. While a strong military core has made NG the successful company it is today, there is no reason it cannot become a more diversified and less military-centric company like Boeing and Lockheed Martin. Having a strong commercial sector adds additional streams of revenue and gives a support cushion if and when the military budget is slashed. Increasing the commercial sector will not only increase streams of revenue, but it will allow the company to charge higher rates, as it is not constrained to the strict regulations of the government, receive a higher return on investment, and help edge ahead of fierce competitors like Raytheon, who operate mostly as a military-centered business like Northrop Grumman is today.

2. Naval UAV/S's/UCAS:

While drones may be the wave of the future of warfare, the air warfare drone market is becoming increasingly crowded. Naval UAVs are going to become a very important function of conducting maritime missions. With growing aggressions from North Korea and China, small virtually undetectable vessels may gain an increasingly important role in patrolling and monitoring the oceans. These machines could also help in detecting mines, as well as launching pre-emptive attacks on enemy vessels from the depths. The Defense Advanced Research Projects Agency (DARPA) has recently (2015) begun constructing a prototype for a naval drone for the U.S. Navy called "Anti-Submarine Warfare Continuous Trail Unmanned Vessel". While Northrop Grumman is not known for having a dominant naval sector, it is known for its UAV technology. With proper research and development, NG may be able to develop UAVs, possibly with attached weapon systems, to become a pioneer in this emerging market, especially to a customer with whom the company already has a relationship. The proposed cost for this project is twenty million dollars. Compared to aerial drones, this is a fraction of the cost. If the government or a government agency can build a naval UAV for twenty million, an efficient company such as Northrop Grumman should be able to do it for less and at a higher quality. This, I believe, along with the above suggestions, is a fantastic opportunity to expand into a new sector with infinite room to grow.

Disclosure:I am/we are long NOC, LMT, RTN, OA, AVAV.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article represents the opinion of the author, who is not a licensed financial advisor. This article is intended for informational and educational purposes only, and should not be construed as investment advice to any particular individual. Readers should perform their own due diligence before making any investment decisions. This is not a recommendation to buy certain stocks because they may be hypothetical acquisition candidates.

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